Enhanced Index-Tracking Strategies Based on Systemic Financial Shocks: A Comparison of Countries Versus Sectors Investments

Since the launch of the first replicating funds in the 1970s, index-linked strategies have captured the interest of equity investors. On the one hand, active investing does not generally lead to higher risk-adjusted returns than a passive approach. On the other hand, passive vehicles cannot optimize the risk exposure to the equity markets without introducing elements of active management. The enhanced index-tracking offers all the advantages of traditional passive investing but aims to generate better returns than the reference benchmark. However, in the last decades, the financial system integration increased, reducing the diversification opportunities across markets, and meanwhile, more and more frequent extreme events affected the world. This amplified systemic instability caused unsatisfactory results even for these investment strategies. To better manage the markets turmoil and reduce losses, we propose alternative portfolio designs to improve the traditional index-tracking techniques. We include the systemic risks directly into the enhanced indexation problem and impose a minimum guaranteed extra-return on the benchmark with turnover control. The analysis builds on country and industry allocation policies in selected European markets from January 2004 to October 2021. Our findings prove that the proposed strategies generate consistent excess returns over the benchmark and outperform other indexing strategies and the equally weighted and risk parity portfolios.